Gavin Lumsden turns to Beefeaters and the Tower of London to help explain what investment trusts are and how they work.

Now we've got unit trusts under our belt it's time to take a look at investment trusts and how they work, in the second part of our guide to investment funds.

To see all the other videos in the Lolly Investor Programme series click here.

Hello and welcome to The Lolly Investor Programme.

This week I’m continuing my look at the main types of investment funds available to private investors with a little help from the Tower of London!

Have I got Jubillee-itis on the brain? Not necessarily. You see this time I'm looking at investment trusts. As these are often described as the ‘hidden jewel’ of the investment world, I thought why not refer to the place where the Crown Jewels are kept?

The most highly prized jewel inside this ancient fortress is the fabulous Koh-i-Nur or Mountain of Light diamond which is the centre piece of the crown of Queen Elizabeth the Queen Mother.

Many investors would like to have that priceless gem sitting in their pension fund wouldn’t they!

But what are investment trusts?

Like unit trusts, which we looked at last time, investment trusts are a form of collective investment scheme, enabling investors to access a wider range of investments than they could do on their own. These investments are managed by a professional fund manager who, by spreading investors’ money around, reduces the risk of any one of the investments failing.

Last time I referred to unit trusts by their other name of ‘open-ended investment companies’ or Oeics. As well as being a mouthful that name was a bit misleading because although they’re open-ended, which means they can expand and contract in response to investor demand, their similarities to a company are actually pretty limited.

Investment trusts, however, are the real thing when it comes to being an investment company.

They are:

Listed on the London Stock Exchange as companies in their own right

They issue shares to investors

Most importantly, they have a board of directors whose job is to ensure the fund manager does a good job, and to protect shareholders’ interests.

The board is accountable to shareholders who have the right to vote at annual general meetings.

They can borrow money to invest more money than they have raised from shareholders. Done well, this borrowing, or gearing, as it is known, can boost shareholder returns. But it also makes investment trusts more risky because if things go wrong, the borrowing can increase shareholder losses.

The oldest investment trusts date back to the 19th century when they were formed to raise money for investing in the construction of the first US railroads.

So why are they the ‘hidden jewel’ if they’ve been around so long?

There is £94 billion held in investment trusts which sounds like a lot of money but is in fact a lot less than is in unit trusts, which also tend to be more expensive.

The reason for this relative lack of appeal goes to the heart of what makes investment trusts different.

In the jargon of the City, investment trusts are said to be ‘closed-ended’, which means they issue a limited number of shares when they launch.

Although they can issue new shares with shareholder approval, their potential to grow in size is more limited than unit trusts which will issue new units and shares to new investors until the cows come home.

This makes trusts a bit like the Tower, which was built with these fixed walls.

However, having its size and boundary set in stone like the Tower is both a strength and a weakness.

To understand why it’s a strength you have to know why buying and selling investment trust shares is fundamentally different from trading in unit trusts.

Let’s say that Beefeater is a stock broker or a financial adviser or an investment website, anyway some kind of middle man through whom I’m buying a fund.

If it’s a unit trust I’m after the Beefeater broker will go to the fund management company inside the walls and buy the units and bring them back to me.

The fund management company will set the price of the unit in relation to the value of the jewels, or assets, it holds in its tower.

This way if you add up all the units they will be worth the same as the jewels it’s bought with investors’ money.

With investment trusts it’s different.

The investment trust issues the shares and puts them on the London Stock Exchange for the investors outside its walls to trade.

So when I go to the Beefeater to buy the investment trust shares he doesn’t go in there to speak to the company, instead he looks around for another investor in the market who wants to sell some shares and puts the two of us together.

In other words it is the market and the transaction between the buyer and seller that sets the price of the shares not the investment trust.

This is very important because it means the trust’s assets, or jewels, are not directly connected to its share price.

This is a strength when stock markets are really bad and some investors are starting to panic sell.

On these occasions a unit trust manager might be forced to sell some jewels at a bad price because it needs the money to pay investors heading for the exit.

By contrast the investment trust can leave its jewels alone, safe in the knowledge that an investor who wants to sell has to fend for themselves in the open market beyond its walls.

This closed ended feature of investment trusts makes them more robust than unit trusts, particularly in volatile or specialist markets.

It is one reason why investment trusts investing in emerging markets have delivered much better long-term investment returns than unit trusts.

However, there is a disadvantage to protecting the trust’s jewels from the trading in its shares outside its walls.

Let’s look again at the way the market prices investment trust shares.

Using information supplied by the investment trust, the market has a good idea of what the jewels, or assets, held by the trust are worth.

However, the simple laws of supply and demand mean the share price can rise above or below the value of the jewels inside the walls.

If the investment trust is run by a really good manager or if it is investing in a hot or fashionable area, there may be lots of investors pestering the Beefeater to buy its shares. If that’s the case the share price will rise.

Similarly, if lots of investors want to sell because performance has been poor, or because they are worried about the market, then the share price will fall.

When an investment trust share price rises above the value of its jewels or assets it is said to be trading at a premium.

If the share price falls below the value of the trust’s assets it is said to be trading at a discount.

Discounts and premiums make investment trusts more complex to invest in than unit trusts, although if you’re a long-term investor you probably don’t need to worry about them too much.

They can also create good trading opportunities for experienced investors.

This is because an investment trust trading at discount is essentially offering a bit of a bargain to new investors. They can pick up a share for less than the value of the assets backing that share.

Similarly, if the trust rises to a premium it can be a good time to sell the share as investors will effectively get more money than they are entitled to.

However, if the discount is too large it will make existing shareholders unhappy. After all it’s the share price that provides the investment return. If the shares are constantly lagging below the trust’s true investment value, something is wrong.

Fortunately, in recent years, investment trust boards have got a lot better at keeping discounts low and looking after shareholders.

This is why investment trusts are enjoying a bit of a renaissance at the moment.

Next week I will look at exchange traded funds, which have become hugely popular in recent years.